Course : Macroeconomics

Effective Period : September 2018

Measuring Nation’s Income

Session 3
Learning Outcome 2:
Calculate measuring GDP and economic growth as monitoring
macroeconomic performance
Measuring a Nation’s Income
• What is Gross Domestic Product (GDP)?
• How is GDP related to a nation’s total income and spending?
• What are the components of GDP?
• How is GDP corrected for inflation?
• Does GDP measure society’s well-being?
 Micro vs. Macro

• Microeconomics:
The study of how individual households and firms make
decisions, interact with one another in markets.
• Macroeconomics:
The study of the economy as a whole.
 Income and Expenditure
• Gross Domestic Product (GDP) measures
total income of everyone in the economy.
• GDP also measures total expenditure on the economy’s output
of g&s.

For the economy as a whole,

income equals expenditure
because every dollar a buyer spends
is a dollar of income for the seller.
 The Circular-Flow Diagram
• a simple depiction of the macroeconomics
• illustrates GDP as spending, revenue,
factor payments, and income
• Preliminaries:
– Factors of production are inputs like labor, land, capital, and
natural resources.
– Factor payments are payments to the factors of production
(e.g., wages, rent).
 The Circular-Flow Diagram

Households:
 own the factors of production,
sell/rent them to firms for income
 buy and consume goods & services

Firms Households

Firms:
 buy/hire factors of production,

use them to produce goods

and services
 The Circular-Flow
Diagram
Revenue (=GDP) Spending (=GDP)
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
 What This Diagram Omits
• The government
– collects taxes, buys g&s
• The financial system
– matches savers’ supply of funds with
borrowers’ demand for loans
• The foreign sector
– trades g&s, financial assets, and currencies with the country’s
residents
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Goods are valued at their market prices, so:

 All goods measured in the same units
(e.g., dollars in the U.S.)
 Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

Final goods: intended for the end user

Intermediate goods: used as components
or ingredients in the production of other goods
GDP only includes final goods—they already embody the
value of the intermediate goods
used in their production.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes tangible goods

(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP measures the value of production that occurs

within a country’s borders, whether done by its own
citizens or by foreigners located there.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Usually a year or a quarter (3 months)

 The Components of GDP
• Recall: GDP is total spending.
• Four components:
– Consumption (C)
– Investment (I)
– Government Purchases (G)
– Net Exports (NX)
• These components add up to GDP (denoted Y):

Y = C + I + G + NX
 Consumption (C)

• is total spending by households on g&s.

• Note on housing costs:
– For renters,
consumption includes rent payments.
– For homeowners,
consumption includes the imputed rental value of the house,
but not the purchase price or mortgage payments.
 Investment (I)

• is total spending on goods that will be used in the future to

produce more goods.
• includes spending on
– capital equipment (e.g., machines, tools)
– structures (factories, office buildings, houses)
– inventories (goods produced but not yet sold)

Note: “Investment” does not

mean the purchase of financial
assets like stocks and bonds.
 Government Purchases (G)
• is all spending on the g&s purchased by govt
at the federal, state, and local levels.
• G excludes transfer payments, such as
Social Security or unemployment insurance benefits.
They are not purchases of g&s.
 Net Exports (NX)
• NX = exports – imports
• Exports represent foreign spending on the economy’s g&s.
• Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
• Adding up all the components of GDP gives:

Y = C + I + G + NX
U.S. GDP and Its Components, 2013

billions % of GDP per capita

Y $16,912 100.0 $53,350

C 11,537 68.2 36,394

I 2,738 16.2 8,637

G 3,137 18.5 9,895

NX –500 –2.9 –1,577

 ACTIVE LEARNING1
GDP and its components

In each of the following cases, determine how much

GDP and each of its components is affected (if at all).
A. Debbie spends $300 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1200 on a new laptop to use in her
publishing business. The laptop was built in China.
C. Jane spends $800 on a computer to use in her
editing business. She got last year’s model on sale
for a great price from a local manufacturer.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them.
ACTIVE LEARNING 1
Answers

A. Debbie spends $300 to buy her husband dinner

at the finest restaurant in Boston.
Consumption and GDP rise by $300.
B. Sarah spends $1200 on a new laptop to use in
her publishing business. The laptop was built in
China.
Investment rises by $1200, net exports fall
by $1200, GDP is unchanged.
 ACTIVE LEARNING 1
Answers

C. Jane spends $800 on a computer to use in her

editing business. She got last year’s model on
sale for a great price from a local manufacturer.
Current GDP and investment do not change,
because the computer was built last year.
D. General Motors builds $500 million worth of
cars, but consumers only buy $470 million of
them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
 Real versus Nominal GDP

• Inflation can distort economic variables like GDP, so we have two

versions of GDP:
• Nominal GDP
– values output using current prices
– not corrected for inflation
• Real GDP
– values output using the prices of a base year
– is corrected for inflation
 EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10 400 $2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200

Compute nominal GDP in each year:

Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
37.5%
2012: $11 x 500 + $2.50 x 1100 = $8,250
2013: $12 x 600 + $3 x 1200 = $10,800 30.9%
 EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10$10 400 $2.00
$2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200

Compute real GDP in each year,

using 2011 as the base year:
Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
20.0%
2012: $10 x 500 + $2 x 1100 = $7,200
16.7%
2013: $10 x 600 + $2 x 1200 = $8,400
 EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
2012 $8250 $7200
2013 $10,800 $8400

In each year,
• nominal GDP is measured using the (then)
current prices.
• real GDP is measured using constant prices
from the base year (2011 in this example).
 EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
37.5% 20.0%
2012 $8250 $7200
2013 $10,800 30.9% $8400 16.7%

• The change in nominal GDP reflects both prices

and quantities.
 The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
 Nominal and Real GDP in the U.S.,
1965–2013
$18,000
$16,000
$14,000 Real GDP
billions

$12,000 (base year

$10,000 2009)
$8,000
$6,000
Nominal
$4,000
GDP
$2,000
$0
19601965197019751980198519901995200020052010
 The GDP Deflator
• The GDP deflator is a measure of the overall level of prices.
• Definition:

nominal GDP
GDP deflator = 100 x
real GDP

 One way to measure the economy’s inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.
 EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2011 $6000 $6000 100.0
14.6%
2012 $8250 $7200 114.6
2013 $10,800 $8400 12.2%
128.6

Compute the GDP deflator in each year:

2011: 100 x (6000/6000) = 100.0

2012: 100 x (8250/7200) = 114.6

2013: 100 x (10,800/8400) = 128.6

 ACTIVE LEARNING 2
Computing GDP

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2011.
B. Compute real GDP in 2012.
C. Compute the GDP deflator in 2013.
 ACTIVE LEARNING 2
Answers

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205

A. Compute nominal GDP in 2011.

$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2012.

$30 x 1000 + $100 x 200 = $50,000
 ACTIVE LEARNING 2
Answers

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205

C. Compute the GDP deflator in 2013.

Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
 GDP and Economic Well-Being
• Real GDP per capita is the main indicator of the average
person’s standard of living.
• But GDP is not a perfect measure of
well-being.
• Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:
 Gross Domestic Product…

“… does not allow for the health of our

children, the quality of their education,
or the joy of their play.
It does not include the beauty of our poetry or the
strength of our marriages, the intelligence of our public
debate or the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country.
It measures everything, in short, except that which makes
life worthwhile, and it can tell us everything about
America except why we are proud that we are Americans.”
- Senator Robert Kennedy, 1968
 GDP Does Not Value:
• the quality of the environment
• leisure time
• non-market activity, such as the child care
a parent provides at home
• an equitable distribution of income
Then Why Do We Care About GDP?
• Having a large GDP enables a country to afford better schools, a
cleaner environment,
health care, etc.
• Many indicators of the quality of life are positively correlated
with GDP. For example…
 GDP and Life Expectancy in 12
90 countries
Bangladesh China Japan
Life expectancy (years)

80 U.S.
Mexico
Brazil Germany
70 Russia
Indonesia
India
60
Pakistan

50 Nigeria

40
$0 $10,000 $20,000 $30,000 $40,000 $50,000

Real GDP per person

 GDP and Average Schooling in 12 countries
14
Germany
Japan
12 U.S.
Average years of school

Russia
10 China
Mexico
8
Brazil
6 Indonesia

4
India

2
$0 $10,000 $20,000 $30,000 $40,000 $50,000

Real GDP per person

 GDP and Water Quality in 12 countries
100%
Indonesia Germany
Satisfaction with water quality

90% Bangladesh U.S.

Japan
Brazil
(% of population)

80%

China
70%
Mexico
India
60%
Pakistan Russia
50%
Nigeria

40%
$0 $10,000 $20,000 $30,000 $40,000 $50,000

Real GDP per person 42

 Summary (1)
• Gross Domestic Product (GDP) measures a country’s total income
and expenditure.
• The four spending components of GDP include: Consumption,
Investment, Government Purchases, and Net Exports.
• Nominal GDP is measured using current prices. Real GDP is
measured using the prices of a constant base year and is
corrected for inflation.
• GDP is the main indicator of a country’s economic well-being, even
though it is not perfect.
 Summary(2)
• People face tradeoffs.
• The cost of any action is measured in terms of foregone
opportunities.
• Rational people make decisions by comparing marginal costs
and marginal benefits.
• People respond to incentives.